F
IGURE
3.2 — D
EMAND FOR
M
ONEY
PPM is very low (prices are high), the demand for cash balances
is very high.
We will now see how the intersection of the falling demand
curve for money or cash balances, and the supply of money, deter-
mines the day-to-day equilibrium PPM or price level.
Suppose that PPM is suddenly very high, that is, prices are
very low. M, the money stock, is given, at $100 billion. As we see
in Figure 3.3,
at a high PPM, the supply of total cash balances, M,
is greater than the demand for money. The difference is surplus
cash balances—money, in the old phrase, that is burning a hole in
people’s pockets. People find that they are suffering from a mon-
etary imbalance: their cash balances are greater than they need at
that price level. And so people start trying to get rid of their cash
balances by spending money on various goods and services.
But while people can get rid of money individually, by buying
things with it, they can’t get
rid of money in the aggregate,
because the $100 billion still exists, and they can’t get rid of it
short of burning it up. But as people spend more, this drives up
demand curves for most or all goods and services. As the demand
curves shift upward and to the right, prices rise. But as prices over-
all rise further and further, PPM begins to fall, as the downward
Money and Overall Prices
33
Chapter Three.qxp 8/4/2008 11:37 AM Page 33
F
IGURE
3.3 —D
ETERMINATION OF THE
P
URCHASING
P
OWER OF
M
ONEY
arrow indicates. And as the PPM begins to fall, the surplus of cash
balances begins to disappear until finally, prices have risen so
much that the $100 billion no longer burns a hole in anyone’s
pocket. At the higher price level, people are now willing to keep
the exact amount of $100 billion that is available in the economy.
The market is at last cleared, and people now wish to hold no
more and no less than the $100 billion available. The demand for
money has been brought into equilibrium
with the supply of
money, and the PPM and price level are in equilibrium. People
were not able to get rid of money in the aggregate, but they were
able to drive up prices so as to end the surplus of cash balances.
Conversely, suppose that prices were suddenly three times as
high and PPM therefore much lower. In that case, people would
need far more cash balances to finance their daily lives, and there
would be a shortage of cash balances compared to the supply of
money available. The demand for cash
balances would be greater
than the total supply. People would then try to alleviate this
34
The Mystery of Banking
Chapter Three.qxp 8/4/2008 11:37 AM Page 34
imbalance, this shortage, by adding to their cash balances. They
can only do so by spending less of their income and adding the
remainder to their cash balance. When they do so, the demand
curves for most or all products will shift downward and to the
left, and prices will generally fall. As prices fall, PPM
ipso facto
rises, as the upward arrow shows. The process will continue until
prices
fall enough and PPM rises, so that the $100 billion is no
longer less than the total amount of cash balances desired.
Once again, market action works to equilibrate supply and
demand for money or cash balances, and demand for money will
adjust to the total supply available. Individuals tried to scramble to
add to their cash balances by spending less; in the aggregate, they
could not add to the money supply, since that is given at $100 bil-
lion. But in the process of spending less, prices
overall fell until the
$100 billion became an adequate total cash balance once again.
The price level, then, and the purchasing power of the dollar,
are determined by the same sort of supply-and-demand feedback
mechanism that determines individual prices. The price level
tends to be at the intersection of the supply of and demand for
money, and tends to return to that point when displaced.
As in individual markets, then, the price or purchasing power
of the dollar varies directly with the demand for money and
inversely with the supply. Or, to turn it around,
the price level
varies directly with the supply of money and inversely with the
demand.
2. W
HY
O
VERALL
P
RICES
C
HANGE
Why does the price level ever change, if the supply of money
and the demand for money determine the height of overall
prices? If, and only if, one or both of these basic factors—the sup-
ply of or demand for money—changes. Let us see what happens
when the supply of money changes, that is, in the modern world,
when the supply of nominal units changes rather than the actual
weight of gold or silver they used to represent.
Let us assume, then,
that the supply of dollars, pounds, or francs increases, without yet
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